Solving California’s budget problems

Gov. Arnold Schwarzenegger and legislators are touting a compromise reached last week as a solution to the state’s $26 billion budget shortfall, but the deal is woefully short of solving all of their problems. California is now so deep in mud that it is still issuing IOUs. So why is California, the state whose gross domestic product rivals that of entire nations, scrambling for stable ground? The answer is structural, and the solution is here.

The California Commission on the 21st Century Economy, better known as the Parsky commission for its chairman, businessman Gerald Parsky of Rancho Santa Fe, has crafted a winning proposal that includes a net receipts tax to replace the corporate income tax and the general fund sales tax, and a single-rate, progressive personal income tax. Enactment of such a bold plan would vault California into the national spotlight and start a wave of state tax reform that the country hasn’t seen since Proposition 13 was adopted 30 years ago.

California now relies heavily on volatile tax revenue sources. The extremely progressive structure of the tax code creates business cycle “bracket creep.” That is, during economic booms individuals move up in tax brackets and during recessions they move down. The result is the state’s $26 billion budget crisis.

Personal income tax reform is politically feasible, as Maine showed recently by simplifying from four brackets to two. If California follows one expected suggestion from the commission—to go from seven brackets to one—its personal income tax would still be progressive and yet provide much steadier revenue.

The net receipts tax is like a traditional value-added tax on business. As a replacement for both the sales and corporate income tax, it would greatly simplify tax administration and eliminate many economic distortions. Regular corporations, so-called C-corporations, will be taxed at the same rate as non-corporate businesses in their various incarnations: limited liability companies, limited liability partnerships, S-corporations, etc. This would begin to make firm structure and decision-making less about taxes and more about efficiency and quality. A competing proposal put together by Fred Keeley, a member of the Parsky commission, is called the Blue Proposal and includes some bold reforms such as reversing the state’s constitutional provision against applying the sales tax to services, and creating a substantial “rainy day” fund. First enacted in 1933, California’s sales tax was logically limited to consumption goods. Now, service industries are the majority of California’s economy yet retain their exemption. The Blue Proposal would undo this constraint, thus broadening and stabilizing a narrow tax.

Rainy day funds are budgetary institutions that have improved the fiscal systems of many states. Whenever California’s revenue exceeded the official revenue estimate by more than 5 percent, the Blue Proposal would funnel the excess into the rainy day fund. Also earmarked for the rainy day fund would be one-third of capital gains tax revenue, in recognition of that tax source’s particularly wild fluctuations. Another third of capital gains revenue would be earmarked for debt resolution, leaving the remaining third for the general fund. Effectively putting aside two-thirds of this volatile revenue source is a positive step away from California’s current roller coaster revenue ride, which all parties agree must end.

One part of the Blue Proposal that is sure to make drivers and homeowners wince is a “pollution tax” on carbon-based fuels. Really a global warming tax, it broadly attempts to discourage the “bad behavior” of using energy for driving or home heating. Even in proposal form, it is overly complex: It suggests a gas rebate and a fluctuating tax rate depending on the daily price of oil. It is also an open invitation for political manipulation, explicitly suggesting exemptions for some industries or businesses. It seems unlikely to achieve the commission’s overall goal, curbing the volatility of gas tax revenue. California wants to be a leader in environmental policy, but a state in budgetary crisis needs a less controversial and complex proposal to raise revenue.

Overall, the main proposal is a superior fundamental tax reform, but it would be wise for the commission to listen to all the reform ideas, and not get stuck on party lines. If enacted, these tax overhauls could succeed in providing more stable tax revenue in California and begin an important nationwide debate on which tax systems have staying power in good and bad times. The commission is still finalizing its proposal to be handed to the governor in September. For the sake of California’s shaky economic future, let’s hope for fundamental change to the state’s fiscal system.

Sheffrin and Cohen are California residents interning with the Washington, D.C.-based Tax Foundation. Sheffrin, a Davis resident, is a student at Wesleyan University in Connecticut. Cohen, a San Diego resident, attends George Washington University in Washington, D.C. A more detailed analysis of California’s tax structure was released this week and can be found at taxfoundation.org.

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